UK - Pension fund trustees have been warned to heed thinking too short-term and seeking refuge in new risk management tools and investment strategies, as a new study claims they give a false sense of security.
The Pension Fund Indicators 2008 study by UBS Global Asset Management suggests pension schemes are embracing more sophisticated techniques and opportunities to control risk and achieve returns, though there are still questions as to how suitable and well-understood these offerings are.
Liability-driven investments (LDI) are increasingly becoming common practice, though the plethora of solutions varies widely and can be misleading, according to UBS: "These so-called LDI solutions vary widely in their detail and the term ‘LDI' is capable of many interpretations."
Moreover, the report questions whether an LDI approach is the best route to take for pension schemes, arguing: "It is debatable whether the focus on risk control will lead to investment strategies more concerned with reducing short-term uncertainty rather than addressing the longer-term need to have sufficient assets to pay pensions."
The report claims trustees are increasingly seeking to use investments and tools more directly aligned to the liabilities of their defined benefit schemes, aimed at attaining a level of return in relation to the scheme's liabilities in a controlled and risk efficient manner, but which often seek an extra return over and above this.
Even though these developments have increased the understanding and appreciation of risk, UBS warns "these tools can give a false sense of security".
The net has been cast ever wider for sources of return, encompassing asset allocation and liability management newcomers such as infrastructure, currency funds and global tactical asset allocation funds, but "risk management tools cannot draw on a long history of data for their modeling of these new investments in the way they can for more traditional asset classes," says the report.
UBS adds: "Furthermore, the characteristics of some investments have evolved or are misleading, so great care is needed in interpreting the results."
Some asset classes which do not involve frequent trading or are not marked to market , for example, will exhibit low volatility, suggests the firm.
In property - which outperformed equities by 5% per annum over 10 years to the end of 2007 - the average gearing of pooled property funds has increased, boosting returns in a rising market, but this has also distorted statistics and compounded losses when the market falls.
The report also claimed the influx of money into private equity has been "extraordinary", though investors should be ready to now face disappointment as the conditions lose their buoyancy.
Change is also beyond alternatives and heading back towards more traditional investments, according to UBS, since boutique equity managers have flourished, buoyed by the boom in returns from smaller and medium-sized companies in the recent market rises, and fuelling the growth of unconstrained long-term equity mandates.
"The concept is attractive but it is difficult to pin down what it means in practice and, crucially, what is the real volatility and correlation with equity markets," argues the report.
UBS concludes it will be "interesting" to see how such strategies fare in the more challenging markets currently faced by pension funds.